No jam today or tomorrow for Britain

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Poor Mervyn King — damned if he doesn’t raise interest rates, futile if he does.

The Bank of England governor is in the unenviable position of having to steer interest rate policy during a period when living standards are being battered, his inflation target is being mocked by even small boys in the street and there is no obvious course of policy which can reconcile the two problems.

The BOE on Wednesday released its quarterly inflation report which judged the chances to be about equal of inflation being above or below its 2 percent target in two years’ time, this despite predicting that it will spike above its current 4 percent rate in the near term.

You might think that presiding over inflation double your target would merit raising rates immediately from all-time lows, but you would, the Governor hastened to imply, be wrong.

“We’re not in the business of futile gestures, we’re in the business of trying to make a dispassionate analysis of the balance of risks to inflation in the medium term,” King told reporters.

Futile is probably just about right, and perhaps a little generous. British inflation has spiked because of global energy and food prices, which will not respond to BOE policy, and because of a rise in consumer taxes which will not be repeated.

At the same time wage growth in Britain is extremely subdued, about 1.8 percent, the economy still has a massive amount of unused capacity and is embarking on a plan of public spending cuts which will throw many out of work and hit government suppliers hard.

The chances of British workers being able to convert rises in inflation into a spiral of wage and further price rises is pretty small at this point.

On top of this, the UK faces two risks, which because they have been around a while get less attention than they should: a weak banking system and a vulnerable property market.

The BOE’s inflation report points out some uncomfortable facts for the banking system: Commercial property, which accounts for about half of loans outstanding, has slid 35 percent in price and many borrowers are in breach of loan terms. Banks have made provisions against some of these loans, but a widespread practice has been to extend terms and wait for a hoped-for recovery in values.

At the same time, the planned removal of government support of banks means between 400 and 500 billion pounds of debt is expiring by the end of 2012, money that will need replacing or will mean a drastic and probably disastrous shrinking in balance sheets.

SHRINKING STANDARD OF LIVING
At the same time, residential property, which has had a miraculously gentle decline, is looking shaky.

So, despite real divisions on the Monetary Policy Committee and expectations among many economists of a rise in rates this Spring, it is very hard to see. The economy might weather the austerity, but then again it might not. The banks and property market may come out OK, but also might not.

As King was quick to point out, the real problem is that the British economy needs reshaping and must do so while paying huge bills racked up by lousy decisions made before the crisis.

Households “are now suffering a squeeze on real living standards for which the current rate of inflation is the obvious symptom but that squeeze on real living standards is going to happen one way or another,” King said.

“It is the price we are all paying for the financial crisis and the subsequent need to rebalance the economy. The only question is, is it better to allow it to happen with a temporary rise in prices or to push down money wages even further …?”

So, no jam today and perhaps no jam tomorrow, an honest assessment if not a popular one.

There is a large danger that the inflation which King says will be “temporary” does not prove to be, a danger that is exacerbated by perceptions that the BOE is reacting to events, perhaps sensibly, but not in strict accordance with their mandate.

My guess is that King is right to allow himself to be damned but to refuse futile acts intended to show his intolerance of inflation.

There may well be a large global bout of inflation, and if there is, Britain will get hurt badly along with the U.S. and most everyone else. If it happens it will be made in Washington, by far more powerful monetary policy, and in Beijing and other emerging markets by demand.

Britain will have to take its lumps and hope for the best.

At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. email: jamessaft@jamessaft.com

The most irritating thing for me is that before the crisis, King stuck rigidly to his ‘mandate’ despite rapidly inflating asset-prices. This was the point at which he should have acted according to wisdom rather than the mandate. But he didn’t, and that (at least in part) is why we now have a crisis.

But post-crisis he appears to have ditched the ‘mandate’, so we’ve still got artificially low interest, even though it’s really too late by now.

I wish that King was at least consistent, but he seems to be exceedingly biased towards the interests of the banks and low interest rates.